Understanding Exchange Traded Funds (ETFs)

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An Exchange-Traded Fund is an investment fund that contains a basket of securities (similar to a mutual fund), and which can be bought and sold all day at market-determined prices (similar to stocks). ETFs are designed to meet specific investment objectives or strategy. The majority of ETFs hold securities that mirror the market index they are set-up to track, and whose returns they attempt to replicate.

Compared to stocks and bonds, ETFs are a relatively new financial product, following their creation in Canada in 1990. The first ETF in the world was known as the Toronto Index Participation Shares (TIPS). ETFs have become very popular with investors who are attracted by their low-fee status, liquidity, and diversification potentials. As of January 2018, the ETF market had grown to over $5 trillion USD in assets under management.

Types of ETFs

An ETF can hold a basket of various asset classes including equities (stocks), fixed income (bonds), commodities, foreign currencies, and others. There are thousands of ETFs available to investors and they can be categorized based on the asset-class of securities they hold, investing management style, industry sector, asset-class size, use of derivatives, and so on.

The main types of ETFs are:

1. Index ETFs: The majority of ETFs are index ETFs. They are designed to track the performance of a market index, which could be a broad index (for example, S&P 500 and S&P/TSX Composite Index) or a sector-specific index (S&P/TSX Capped Utilities Index).

Index ETFs utilize a passive investing style in that they hold securities representative of their benchmark index, and do not attempt to outperform the index (market) by frequently buying and selling securities being held. Index ETFs can track stock, bond, commodity, and other indices.

2. Actively Managed ETFs: Unlike Index ETFs, actively-managed ETFs do not track any single market index. These ETFs attempt to “beat the market” by actively picking securities that are expected to perform well. As a result of active management, the MER of actively-managed ETFs are higher compared to an index ETF.

4. International ETFs: These ETFs expose investors to international stock and bond markets. They can be categorized further into Global ETFs, Developed Market ETFs, Emerging Market ETFs, Frontier Market ETFs, etc.

Examples of international ETFs include iShares Core MSCI All Country World ex Canada Index ETF (XAW) and Vanguard FTSE Emerging Markets All Cap Index ETF (VEE)

5. Fixed Income or Bond ETFs: As the main implies, a bond ETF tracks a broad-market or sector-specific bond index, and attempts to replicate its performance.

7. Commodity ETFs: These ETFs expose investors to commodity markets by either purchasing the physical commodity (such as gold, corn, wheat, soybeans, cotton, cocoa, sugar), investing in equities of companies that are involved in those commodities (such as Miners), or through the use of commodity futures contracts.

Examples of commodity ETFs include Horizons Gold ETF (HUG), iShares S&P/TSX Global Gold Index ETF (XGD) and BMO Junior Oil Index ETF (ZJO). Investors may use commodity ETFs to further diversify their investment portfolio, while also taking advantage of the opposite correlation that some commodities have relative to stocks.

8. Currency ETFs: These ETFs may track a single or multiple-currency indices e.g. Horizons U.S. Dollar Currency ETF (DLR).

9. Leveraged ETFs: These are ETFs that aim to double or even triple the performance of a particular index they are tracking. They use financial derivatives and debt (leverage) to amplify their returns and are considered to be complex and highly speculative investments. They do get expensive on fees because a lot of active trading/management is involved.

10. Inverse ETFs: An inverse ETF is designed to move in the opposite direction of the index it is tracking. For example, if the benchmark index falls by 5%, the inverse ETF tracking it is expected to rise by 5%, and vice-versa. Like leveraged ETFs, they also involve the use of complex instruments – derivatives.

Differences between ETFs and Mutual Funds include:

Market Pricing and Trading: ETF units can be traded (bought and sold) throughout the day on a stock exchange and experience price changes just like stocks. In contrast, mutual funds do not have their prices fluctuating throughout the day due to forces of supply and demand and are not traded all day long. The price of individual mutual fund shares is determined at the close of day when the fund’s net asset value (NAV) is calculated, and the price stays the same until the NAV is calculated again at the close of the next trading day.

Because ETF unit prices change throughout the trading day like stocks, investors can place market orders, limit orders, stop-loss orders, etc. just like for normal stock trading.

Management Expense Ratio (MER): The management fees charged for ETFs are usually lower than for mutual funds. The reason for this goes back to active management. Most mutual funds are actively managed and this activity results in more buying and selling activity (transaction costs) and more work by fund managers.

Lower fees for ETFs is one of the main drivers of their popularity because investors understand that they can increase their long-term returns by slashing their fees expense. There are equity ETFs with MER as low as 0.03%, compared to 2% or more for the average equity mutual fund.

Note that when ETFs are purchased through a brokerage account, the investor may be charged a fee (brokerage commission) per transaction.

Liquidity: Because ETFs can be traded all day on a stock exchange when the markets are open, they offer better liquidity than mutual funds.

Other benefits and attractions of ETFs include:

Tax Efficiency: There is a lower turnover of securities associated with an ETF portfolio because due to the passive investing strategy, there is less buying and selling activity. With less trading going on, there is less capital gains distribution, enabling greater tax efficiency. Any taxes due on capital gains become due when you sell your ETF holding.

Transparency: it is easy to find out what securities an ETF holds in their portfolio at any point in time, and in what proportion.

Costs of Investing With ETFs

MER: ETFs usually come with lower MERs compared to their mutual fund counterparts. The Management Expense Ratio (MER) is a combination of a management fee and operating expenses. The management fee is comprised mainly of the salary of the fund manager and other members of the investment team. Operating expenses include admin, legal, and audit fees; prospectuses, mailing, and stationery expenses. The MER is calculated as a percentage of the fund’s assets and is shown in the fund’s prospectus.

Commissions: Although ETFs do not charge sales loads like mutual funds, brokerages generally charge commissions per transaction i.e. when you buy and/or sell. These fees can add up to become a significant expense if you trade frequently. Some discount brokerages offer commission-free ETFs.

Bid-Ask Spreads: Differences between the bid (buy) and ask (sell) price of an ETF indirectly add to the costs of investing using ETFs. The spread means that if you buy an ETF unit and immediately sell it, you will still incur a transaction cost that is equal to the difference between the lowest price sellers are willing to sell for (ask price) and the highest price that buyers are willing to pay (bid price). Essentially, you buy for slightly more and sell for a bit less. When an ETF is traded actively, the spread between the buy and sell price narrows, reducing this transaction cost.

ETF Providers in Canada

The number of companies offering ETFs continues to increase rapidly every year as investors keep pulling funds from mutual funds and divert them to ETFs. Some of the largest ETF providers in Canada include:

Conclusion

All investing activities carry some level of risk, and ETFs are no different. ETFs are associated with lower expense ratios, but if you are not a “buy and wait” long-term investor, it is important you also consider the brokerage commissions charged when looking at your overall investment fees.

ETFs are mostly taxed like mutual funds – you pay taxes on dividends and capital gains. The taxes due will differ depending on whether you are investing within a registered (RRSP, RRIF) or non-registered account, TFSA, using foreign-listed ETFs (U.S. and International), Equity or Bond ETFs.

To invest in ETFs, you can use a full-service brokerage (they trade on your behalf) or a discount brokerage (DIY investing option). Some of the major online discount brokerages in Canada include Questrade, ScotiaiTrade, RBC Direct Investing, TD Waterhouse, Qtrade, and BMO InvestorLine.